Basel Committee on Banking Supervision. Principles for Sound Liquidity Risk Management and Supervision

Transcription

1 Basel Committee on Banking Supervision Principles for Sound Liquidity Risk Management and Supervision September 2008

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3 Requests for copies of publications, or for additions/changes to the mailing list, should be sent to: Bank for International Settlements Press & Communications CH-4002 Basel, Switzerland Fax: and Bank for International Settlements All rights reserved. Brief excerpts may be reproduced or translated provided the source is stated. ISBN print: ISBN web:

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5 Table of Contents Introduction...1 Principles for the management and supervision of liquidity risk...3 Fundamental principle for the management and supervision of liquidity risk...3 Governance of liquidity risk management...3 Measurement and management of liquidity risk...3 Public disclosure...4 The role of supervisors...4 Fundamental principle for the management and supervision of liquidity risk...6 Principle Governance of liquidity risk management...7 Principle Principle Principle Measurement and management of liquidity risk...10 Principle Principle Principle Principle Principle Principle Principle Principle Public disclosure...31 Principle The Role of Supervisors...32 Principle Principle Principle Principle List of members of the Working Group on Liquidity...37

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7 Principles for Sound Liquidity Risk Management and Supervision Introduction 1. Liquidity is the ability of a bank 1 to fund increases in assets and meet obligations as they come due, without incurring unacceptable losses. The fundamental role of banks in the maturity transformation of short-term deposits into long-term loans makes banks inherently vulnerable to liquidity risk, 2 both of an institution-specific nature and that which affects markets as a whole. Virtually every financial transaction or commitment has implications for a bank s liquidity. Effective liquidity risk management helps ensure a bank's ability to meet cash flow obligations, which are uncertain as they are affected by external events and other agents' behaviour. Liquidity risk management is of paramount importance because a liquidity shortfall at a single institution can have system-wide repercussions. Financial market developments in the past decade have increased the complexity of liquidity risk and its management. 2. The market turmoil that began in mid-2007 re-emphasised the importance of liquidity to the functioning of financial markets and the banking sector. In advance of the turmoil, asset markets were buoyant and funding was readily available at low cost. The reversal in market conditions illustrated how quickly liquidity can evaporate and that illiquidity can last for an extended period of time. The banking system came under severe stress, which necessitated central bank action to support both the functioning of money markets and, in a few cases, individual institutions. 3. In February 2008 the Basel Committee on Banking Supervision 3 published Liquidity Risk Management and Supervisory Challenges. The difficulties outlined in that paper highlighted that many banks had failed to take account of a number of basic principles of liquidity risk management when liquidity was plentiful. Many of the most exposed banks did not have an adequate framework that satisfactorily accounted for the liquidity risks posed by individual products and business lines, and therefore incentives at the business level were misaligned with the overall risk tolerance of the bank. Many banks had not considered the amount of liquidity they might need to satisfy contingent obligations, either contractual or non-contractual, as they viewed funding of these obligations to be highly unlikely. Many firms The term bank as used in this document generally refers to banks, bank holding companies or other companies considered by banking supervisors to be the parent of a banking group under applicable national law as determined to be appropriate by the entity s national supervisor. This paper makes no distinction in application to banks or bank holding companies, unless explicitly noted or otherwise indicated by the context. This paper focuses primarily on funding liquidity risk. Funding liquidity risk is the risk that the firm will not be able to meet efficiently both expected and unexpected current and future cash flow and collateral needs without affecting either daily operations or the financial condition of the firm. Market liquidity risk is the risk that a firm cannot easily offset or eliminate a position at the market price because of inadequate market depth or market disruption. The Basel Committee on Banking Supervision is a committee of banking supervisory authorities which was established by the central bank Governors of the G10 countries in It is made up of senior representatives of banking supervisory authorities and central banks from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom and the United States. In addition to participants from these countries, representatives from Australia, China, Hong Kong SAR, Singapore and the Committee on Payment and Settlement Systems participated in developing this guidance. Principles for Sound Liquidity Risk Management and Supervision 1

8 viewed severe and prolonged liquidity disruptions as implausible and did not conduct stress tests that factored in the possibility of market wide strain or the severity or duration of the disruptions. Contingency funding plans (CFPs) were not always appropriately linked to stress test results and sometimes failed to take account of the potential closure of some funding sources. 4. In order to account for financial market developments as well as lessons learned from the turmoil, the Basel Committee has conducted a fundamental review of its 2000 Sound Practices for Managing Liquidity in Banking Organisations. Guidance has been significantly expanded in a number of key areas. In particular, more detailed guidance is provided on: the importance of establishing a liquidity risk tolerance; the maintenance of an adequate level of liquidity, including through a cushion of liquid assets; the necessity of allocating liquidity costs, benefits and risks to all significant business activities; the identification and measurement of the full range of liquidity risks, including contingent liquidity risks; the design and use of severe stress test scenarios; the need for a robust and operational contingency funding plan; the management of intraday liquidity risk and collateral; and public disclosure in promoting market discipline. 5. Guidance for supervisors also has been augmented substantially. The guidance emphasises the importance of supervisors assessing the adequacy of a bank s liquidity risk management framework and its level of liquidity, and suggests steps that supervisors should take if these are deemed inadequate. The principles also stress the importance of effective cooperation between supervisors and other key stakeholders, such as central banks, especially in times of stress. 6. This guidance focuses on liquidity risk management at medium and large complex banks, but the sound principles have broad applicability to all types of banks. The implementation of the sound principles by both banks and supervisors should be tailored to the size, nature of business and complexity of a bank s activities. A bank and its supervisors also should consider the bank s role in the financial sectors of the jurisdictions in which it operates and the bank s systemic importance in those financial sectors. The Basel Committee fully expects banks and national supervisors to implement the revised principles promptly and thoroughly and the Committee will actively review progress in implementation. 7. This guidance is arranged around seventeen principles for managing and supervising liquidity risk. These principles are as follows: 2 Principles for Sound Liquidity Risk Management and Supervision

9 Principles for the management and supervision of liquidity risk Fundamental principle for the management and supervision of liquidity risk Principle 1: A bank is responsible for the sound management of liquidity risk. A bank should establish a robust liquidity risk management framework that ensures it maintains sufficient liquidity, including a cushion of unencumbered, high quality liquid assets, to withstand a range of stress events, including those involving the loss or impairment of both unsecured and secured funding sources. Supervisors should assess the adequacy of both a bank's liquidity risk management framework and its liquidity position and should take prompt action if a bank is deficient in either area in order to protect depositors and to limit potential damage to the financial system. Governance of liquidity risk management Principle 2: A bank should clearly articulate a liquidity risk tolerance that is appropriate for its business strategy and its role in the financial system. Principle 3: Senior management should develop a strategy, policies and practices to manage liquidity risk in accordance with the risk tolerance and to ensure that the bank maintains sufficient liquidity. Senior management should continuously review information on the bank s liquidity developments and report to the board of directors on a regular basis. A bank s board of directors should review and approve the strategy, policies and practices related to the management of liquidity at least annually and ensure that senior management manages liquidity risk effectively. Principle 4: A bank should incorporate liquidity costs, benefits and risks in the internal pricing, performance measurement and new product approval process for all significant business activities (both on- and off-balance sheet), thereby aligning the risk-taking incentives of individual business lines with the liquidity risk exposures their activities create for the bank as a whole. Measurement and management of liquidity risk Principle 5: A bank should have a sound process for identifying, measuring, monitoring and controlling liquidity risk. This process should include a robust framework for comprehensively projecting cash flows arising from assets, liabilities and off-balance sheet items over an appropriate set of time horizons. Principle 6: A bank should actively monitor and control liquidity risk exposures and funding needs within and across legal entities, business lines and currencies, taking into account legal, regulatory and operational limitations to the transferability of liquidity. Principle 7: A bank should establish a funding strategy that provides effective diversification in the sources and tenor of funding. It should maintain an ongoing presence in its chosen funding markets and strong relationships with funds providers Principles for Sound Liquidity Risk Management and Supervision 3

10 to promote effective diversification of funding sources. A bank should regularly gauge its capacity to raise funds quickly from each source. It should identify the main factors that affect its ability to raise funds and monitor those factors closely to ensure that estimates of fund raising capacity remain valid. Principle 8: A bank should actively manage its intraday liquidity positions and risks to meet payment and settlement obligations on a timely basis under both normal and stressed conditions and thus contribute to the smooth functioning of payment and settlement systems. Principle 9: A bank should actively manage its collateral positions, differentiating between encumbered and unencumbered assets. A bank should monitor the legal entity and physical location where collateral is held and how it may be mobilised in a timely manner. Principle 10: A bank should conduct stress tests on a regular basis for a variety of short-term and protracted institution-specific and market-wide stress scenarios (individually and in combination) to identify sources of potential liquidity strain and to ensure that current exposures remain in accordance with a bank s established liquidity risk tolerance. A bank should use stress test outcomes to adjust its liquidity risk management strategies, policies, and positions and to develop effective contingency plans. Principle 11: A bank should have a formal contingency funding plan (CFP) that clearly sets out the strategies for addressing liquidity shortfalls in emergency situations. A CFP should outline policies to manage a range of stress environments, establish clear lines of responsibility, include clear invocation and escalation procedures and be regularly tested and updated to ensure that it is operationally robust. Principle 12: A bank should maintain a cushion of unencumbered, high quality liquid assets to be held as insurance against a range of liquidity stress scenarios, including those that involve the loss or impairment of unsecured and typically available secured funding sources. There should be no legal, regulatory or operational impediment to using these assets to obtain funding. Public disclosure Principle 13: A bank should publicly disclose information on a regular basis that enables market participants to make an informed judgement about the soundness of its liquidity risk management framework and liquidity position. The role of supervisors Principle 14: Supervisors should regularly perform a comprehensive assessment of a bank s overall liquidity risk management framework and liquidity position to determine whether they deliver an adequate level of resilience to liquidity stress given the bank s role in the financial system. 4 Principles for Sound Liquidity Risk Management and Supervision

11 Principle 15: Supervisors should supplement their regular assessments of a bank s liquidity risk management framework and liquidity position by monitoring a combination of internal reports, prudential reports and market information. Principle 16: Supervisors should intervene to require effective and timely remedial action by a bank to address deficiencies in its liquidity risk management processes or liquidity position. Principle 17: Supervisors should communicate with other supervisors and public authorities, such as central banks, both within and across national borders, to facilitate effective cooperation regarding the supervision and oversight of liquidity risk management. Communication should occur regularly during normal times, with the nature and frequency of the information sharing increasing as appropriate during times of stress. Principles for Sound Liquidity Risk Management and Supervision 5

12 Fundamental principle for the management and supervision of liquidity risk Principle 1 A bank is responsible for the sound management of liquidity risk. A bank should establish a robust liquidity risk management framework that ensures it maintains sufficient liquidity, including a cushion of unencumbered, high quality liquid assets, to withstand a range of stress events, including those involving the loss or impairment of both unsecured and secured funding sources. Supervisors should assess the adequacy of both a bank's liquidity risk management framework and its liquidity position and should take prompt action if a bank is deficient in either area in order to protect depositors and to limit potential damage to the financial system. 8. A bank should establish a robust liquidity risk management framework that is well integrated into the bank-wide risk management process. A primary objective of the liquidity risk management framework should be to ensure with a high degree of confidence that the firm is in a position to both address its daily liquidity obligations and withstand a period of liquidity stress affecting both secured and unsecured funding, the source of which could be bank-specific or market-wide. In addition to maintaining sound liquidity risk governance and management practices, as discussed further below, a bank should hold an adequate liquidity cushion comprised of readily marketable assets to be in a position to survive such periods of liquidity stress. A bank should demonstrate that its liquidity cushion is commensurate with the complexity of its on- and off-balance sheet activities, the liquidity of its assets and liabilities, the extent of its funding mismatches and the diversity of its business mix and funding strategies. A bank should use appropriately conservative assumptions about the marketability of assets and its access to funding, both secured and unsecured, during periods of stress. Moreover, a bank should not allow competitive pressures to compromise the integrity of its liquidity risk management, control functions, limit systems and liquidity cushion. 9. It is essential for supervisors to address liquidity risk as thoroughly as other major risks. The aim of liquidity supervision and regulation is to reduce the frequency and severity of banks liquidity problems, in order to lower their potential impact on the financial system and broader economy and to protect deposit holders. Even though strong capital positions reduce the likelihood of liquidity pressure, apparently solvent banks can suffer liquidity problems. Liquidity problems are typically low frequency but potentially high impact events, and the board of directors and senior management of a bank may pay more attention to other, higher frequency risks or may limit a bank s liquidity risk mitigation due to competitive considerations. In addition, an expectation that central banks will provide liquidity support, alongside the guarantees to depositors provided by deposit insurance, could diminish the incentives of the bank to manage its liquidity as conservatively as it should. This increases the responsibility of supervisors to ensure that a bank does not lower its standard of liquidity risk management and adopt a less robust liquidity risk management framework as a result. Drawing on their experience and knowledge of a range of institutions in their jurisdictions, supervisors should assess whether each bank manages liquidity risk robustly to maintain sufficient liquidity and should take supervisory action if a bank is not holding sufficient liquidity to enable it to survive a period of severe liquidity stress. 6 Principles for Sound Liquidity Risk Management and Supervision

13 Governance of liquidity risk management Principle 2 A bank should clearly articulate a liquidity risk tolerance that is appropriate for the business strategy of the organisation and its role in the financial system. 10. A bank should set a liquidity risk tolerance in light of its business objectives, strategic direction and overall risk appetite. The board of directors is ultimately responsible for the liquidity risk assumed by the bank and the manner in which this risk is managed and therefore should establish the bank s liquidity risk tolerance. The tolerance, which should define the level of liquidity risk that the bank is willing to assume, should be appropriate for the business strategy of the bank and its role in the financial system and should reflect the bank s financial condition and funding capacity. The tolerance should ensure that the firm manages its liquidity strongly in normal times in such a way that it is able to withstand a prolonged period of stress. The risk tolerance should be articulated in such a way that all levels of management clearly understand the trade-off between risks and profits. There are a variety of qualitative and quantitative ways in which a bank can express its risk tolerance. For example, a bank may quantify its liquidity risk tolerance in terms of the level of unmitigated funding liquidity risk the bank decides to take under normal and stressed business conditions. As discussed in Principle 14, supervisors will assess the appropriateness of the bank s risk tolerance and any changes to the risk tolerance over time. Principle 3 Senior management should develop a strategy, policies and practices to manage liquidity risk in accordance with the risk tolerance and to ensure that the bank maintains sufficient liquidity. Senior management should continuously review information on the bank s liquidity developments and report to the board of directors on a regular basis. A bank s board of directors 4 should review and approve the strategy, policies and practices related to the management of liquidity at least annually and ensure that senior management manages liquidity risk effectively. 11. Senior management is responsible for developing and implementing a liquidity risk management strategy in accordance with the bank s risk tolerance. The strategy should include specific policies on liquidity management, such as: the composition and maturity of assets and liabilities; the diversity and stability of funding sources; the approach to managing liquidity in different currencies, across borders, and across business lines and legal entities; the approach to intraday liquidity management; and the assumptions on the liquidity and marketability of assets. The strategy should take account of liquidity needs under normal conditions as well as liquidity implications under periods of liquidity stress, the nature of which may be institution-specific or market-wide or a combination of the two. The strategy may include various high-level quantitative and qualitative targets. The board of directors should approve the strategy and critical policies and practices and review them at least 4 The Committee is aware that there are significant differences in legislative and regulatory frameworks across countries as regards the functions of the board of directors and senior management. In some countries, the board has the main, if not exclusive, function of supervising the executive body (senior management, general management) so as to ensure that the latter fulfils its tasks. For this reason, in some cases, it is known as a supervisory board. This means that the board has no executive functions. In other countries, by contrast, the board has a broader competence in that it lays down the general framework for the management of the bank. Owing to these differences, the notions of the board of directors and senior management are used in this paper not to identify legal constructs but rather to label two decision-making functions within a bank. Principles for Sound Liquidity Risk Management and Supervision 7

14 annually. The board should ensure that senior management translates the strategy into clear guidance and operating standards (eg in the form of policies, controls or procedures). The board should also ensure that senior management and appropriate personnel have the necessary expertise and that the bank has processes and systems to measure, monitor, and control all sources of liquidity risk. 12. The liquidity strategy should be appropriate for the nature, scale and complexity of a bank s activities. In formulating this strategy, the bank should take into consideration its legal structures (eg mix of foreign branches versus foreign operating subsidiaries), key business lines, the breadth and diversity of markets, products, and jurisdictions in which it operates, and home and host regulatory requirements. 13. Senior management should determine the structure, responsibilities and controls for managing liquidity risk and for overseeing the liquidity positions of all legal entities, branches and subsidiaries in the jurisdictions in which a bank is active, and outline these elements clearly in the bank s liquidity policies. The structure for managing liquidity (ie the degree of centralisation or decentralisation of a bank s liquidity risk management) should take into consideration any legal, regulatory or operational restrictions on the transfer of funds. In some cases there may be strict regulatory restrictions on funds being transferred between entities or jurisdictions. When a group contains both bank and non-bank entities, group level management should understand the different liquidity risk characteristics specific to each entity, both with respect to the nature of the business and with respect to the regulatory environment. Whatever structure is employed, senior management should be able to monitor the liquidity risks across the banking group and at each entity on an ongoing basis. Processes should be in place to ensure that the group s senior management is actively monitoring and quickly responding to all material developments across the group and reporting to the board of directors as appropriate. 14. In addition, senior management and the board should have a thorough understanding of the close links between funding liquidity risk and market liquidity risk, as well as how other risks, including credit, market, operational and reputation risks affect the bank s overall liquidity risk strategy. 15. The liquidity strategy, key policies for implementing the strategy, and the liquidity risk management structure should be communicated throughout the organisation by senior management. All business units conducting activities that have an impact on liquidity should be fully aware of the liquidity strategy and operate under the approved policies, procedures, limits and controls. Individuals responsible for liquidity risk management should maintain close links with those monitoring market conditions, as well as with other individuals with access to critical information, such as credit risk managers. Moreover, liquidity risk and its potential interaction with other risks should be included in the risks addressed by risk management committees and/or independent risk management functions. 16. Senior management should ensure that the bank has adequate internal controls to ensure the integrity of its liquidity risk management process. Senior management should ensure that operationally independent, appropriately trained and competent personnel are responsible for implementing internal controls. It is critical that personnel in independent control functions have the skills and authority to challenge information and modelling assumptions provided by business lines. When significant changes impact the effectiveness of controls and revisions or enhancements to internal controls are warranted, senior management should ensure that necessary changes are implemented in a timely manner. Internal audit should regularly review the implementation and effectiveness of the agreed framework for controlling liquidity risk. 8 Principles for Sound Liquidity Risk Management and Supervision

15 17. Senior management should closely monitor current trends and potential market developments that may present significant, unprecedented and complex challenges for managing liquidity risk so that they can make appropriate and timely changes to the liquidity strategy as needed. Senior management should define the specific procedures and approvals necessary for exceptions to policies and limits, including the escalation procedures and follow-up actions to be taken for breaches of limits. Senior management should ensure that stress tests, contingency funding plans and liquidity cushions are effective and appropriate for the bank, as discussed in later principles. 18. The board should review regular reports on the liquidity position of the bank. The board should be informed immediately of new or emerging liquidity concerns. These include increasing funding costs or concentrations, the growing size of a funding gap, the drying up of alternative sources of liquidity, material and/or persistent breaches of limits, a significant decline in the cushion of unencumbered, highly liquid assets, or changes in external market conditions which could signal future difficulties. The board should ensure that senior management takes appropriate remedial actions to address the concerns. Principle 4 A bank should incorporate liquidity costs, benefits and risks in the internal pricing, performance measurement and new product approval process for all significant business activities (both on- and off-balance sheet), thereby aligning the risk-taking incentives of individual business lines with the liquidity risk exposures their activities create for the bank as a whole. 19. Senior management should appropriately incorporate liquidity costs, benefits and risks in the internal pricing, performance measurement and new product approval process for all significant business activities (both on- and off-balance sheet). Senior management should ensure that a bank s liquidity management process includes measurement of the liquidity costs, benefits and risks implicit in all significant business activities, including activities that involve the creation of contingent exposures which may not immediately have a direct balance sheet impact. These costs, benefits and risks should then be explicitly attributed to the relevant activity so that line management incentives are consistent with and reinforce the overarching liquidity risk tolerance and strategy of the bank, with a liquidity charge assigned as appropriate to positions, portfolios, or individual transactions. This assignment of liquidity costs, benefits and risks should incorporate factors related to the anticipated holding periods of assets and liabilities, their market liquidity risk characteristics, and any other relevant factors, including the benefits from having access to relatively stable sources of funding, such as some types of retail deposits. 20. The quantification and attribution of these risks should be explicit and transparent at the line management level and should include consideration of how liquidity would be affected under stressed conditions. 21. The analytical framework should be reviewed as appropriate to reflect changing business and financial market conditions and so maintain the appropriate alignment of incentives. Moreover, liquidity risk costs, benefits and risks should be addressed explicitly in the new product approval process. Principles for Sound Liquidity Risk Management and Supervision 9

16 Measurement and management of liquidity risk Principle 5 A bank should have a sound process for identifying, measuring, monitoring and controlling liquidity risk. This process should include a robust framework for comprehensively projecting cash flows arising from assets, liabilities and off-balance sheet items over an appropriate set of time horizons. 22. A bank should define and identify the liquidity risk to which it is exposed for all legal entities, branches and subsidiaries in the jurisdictions in which it is active. A bank s liquidity needs and the sources of liquidity available to meet those needs depend significantly on the bank s business and product mix, balance sheet structure and cash flow profiles of its onand off-balance sheet obligations. As a result, a bank should evaluate each major on and offbalance sheet position, including the effect of embedded options and other contingent exposures that may affect the bank s sources and uses of funds, and determine how it can affect liquidity risk. 23. A bank should consider the interactions between exposures to funding liquidity risk and market liquidity risk 5. A bank that obtains liquidity from capital markets should recognise that these sources may be more volatile than traditional retail deposits. For example, under conditions of stress, investors in money market instruments may demand higher compensation for risk, require roll over at considerably shorter maturities, or refuse to extend financing at all. Moreover, reliance on the full functioning and liquidity of financial markets may not be realistic as asset and funding markets may dry up in times of stress. Market illiquidity may make it difficult for a bank to raise funds by selling assets and thus increase the need for funding liquidity. 24. A bank should ensure that assets are prudently valued according to relevant financial reporting and supervisory standards. A bank should fully factor into its risk management the consideration that valuations may deteriorate under market stress, and take this into account in assessing the feasibility and impact of asset sales during stress on its liquidity position. For example, a bank s sale of assets under duress to raise liquidity could put pressure on earnings and capital and further reduce counterparties confidence in the bank, further constraining its access to funding markets. In addition, a large asset sale by one bank may prompt further price declines for that type of asset due to the market s difficulty in absorbing the sale. Finally, the interaction of funding liquidity risk and market liquidity risk may lead to illiquidity spirals, with banks stockpiling liquidity and not on-lending in term interbank markets because of pessimistic assumptions about future market conditions and their own ability to raise additional funds quickly in the event of an adverse shock. 25. A bank should recognise and consider the strong interactions between liquidity risk and the other types of risk to which it is exposed. Various types of financial and operating risks, including interest rate, credit, operational, legal and reputational risks, may influence a bank s liquidity profile. Liquidity risk often can arise from perceived or actual weaknesses, failures or problems in the management of other risk types. A bank should identify events that could have an impact on market and public perceptions about its soundness, particularly in wholesale markets. 5 See footnote 2 for definitions of funding liquidity risk and market liquidity risk. 10 Principles for Sound Liquidity Risk Management and Supervision

17 26. Liquidity measurement involves assessing a bank s cash inflows against its outflows and the liquidity value of its assets to identify the potential for future net funding shortfalls. A bank should be able to measure and forecast its prospective cash flows for assets, liabilities, off-balance sheet commitments and derivatives over a variety of time horizons, under normal conditions and a range of stress scenarios, including scenarios of severe stress. 27. Regarding the time horizons over which to identify, measure, monitor and control liquidity risk, a bank should ensure that its liquidity risk management practices integrate and consider a variety of factors. These include vulnerabilities to changes in liquidity needs and funding capacity on an intraday basis; day-to-day liquidity needs and funding capacity over short and medium-term horizons up to one year; longer-term liquidity needs over one year; and vulnerabilities to events, activities and strategies that can put a significant strain on internal cash generation capability. 28. A bank should identify, measure, monitor and control a bank s liquidity risk positions for: (a) (b) (c) (d) future cash flows of assets and liabilities; sources of contingent liquidity demand and related triggers associated with offbalance sheet positions; currencies in which a bank is active; and correspondent, custody and settlement activities. (a) Future cash flows of assets and liabilities 29. A bank should have a robust liquidity risk management framework providing prospective, dynamic cash flow forecasts that include assumptions on the likely behavioural responses of key counterparties to changes in conditions and are carried out at a sufficiently granular level. A bank should make realistic assumptions about its future liquidity needs for both the short- and long-term that reflect the complexities of its underlying businesses, products and markets. A bank should analyse the quality of assets that could be used as collateral, in order to assess their potential for providing secured funding in stressed conditions. A bank also should attempt to manage the timing of incoming flows in relation to known outgoing sources in order to obtain an appropriate maturity distribution for its sources and uses of funds. 30. In estimating the cash flows arising from its liabilities, a bank should assess the stickiness of its funding sources that is, their tendency not to run off quickly under stress. In particular, for large wholesale funds providers, both secured and unsecured, a bank should assess the likelihood of roll-over of funding lines and the potential for fund providers to behave similarly under stress, and therefore consider the possibility that secured and unsecured funding might dry up in times of stress. For secured funding with overnight maturity, a bank should not assume that the funding will automatically roll over. In addition, a bank should assess the availability of term funding back up facilities and the circumstances under which they can be utilised. A bank should also consider factors that influence the stickiness of retail deposits, such as size, interest-rate sensitivity, geographical location of depositors and the deposit channel (eg direct, internet or brokered). In addition, national differences in deposit insurance regimes can have a material impact on the stickiness of customer deposits. In times of stress, the coverage and the actual or perceived speed with which a depositor is paid out through a national deposit insurance regime, as well as the manner in which problem banks are resolved in a jurisdiction, can affect the behaviour of retail depositors. Principles for Sound Liquidity Risk Management and Supervision 11

18 (b) Sources of contingent liquidity demand and related triggers associated with off-balance sheet positions 31. A bank should identify, measure, monitor and control potential cash flows relating to off-balance sheet commitments and other contingent liabilities. This should include a robust framework for projecting the potential consequences of undrawn commitments being drawn, considering the nature of the commitment and credit worthiness of the counterparty, as well as exposures to business and geographical sectors, as counterparties in the same sectors may be affected by stress at the same time. 32. A bank issuer should monitor, at inception and throughout the life of the transaction, the potential risks arising from the existence of recourse provisions in asset sales, the extension of liquidity facilities to securitisation programmes and the early amortisation triggers of certain asset securitisation transactions. 33. A bank s processes for identifying and measuring contingent funding risks should consider the nature and size of the bank s potential non-contractual obligations, as such obligations can give rise to the bank supporting related off-balance sheet vehicles in times of stress. This is particularly true of securitisation and conduit programmes where the bank considers such support critical to maintaining ongoing access to funding. Similarly, in times of stress, reputational concerns might prompt a bank to purchase assets from money market or other investment funds that it manages or with which it is otherwise affiliated. 34. Given the customised nature of many of the contracts that underlie undrawn commitments and off-balance sheet instruments, triggering events 6 for these contingent liquidity risks can be difficult to model. It is incumbent upon the management of the riskoriginating business activity, as well as the liquidity risk management group, to implement systems and tools to analyse these liquidity trigger events effectively and to measure how changes to underlying risk factors could cause draws against these facilities, even if there has been no historical evidence of such draws. This analysis should include appropriate assumptions on the behaviour of both the bank and its obligors or counterparties. 35. The management of liquidity risks of certain off-balance sheet items is of particular importance due to their prevalence and the difficulties that many banks have in assessing the related liquidity risks that could materialise in times of stress. Those items include special purpose vehicles; financial derivatives; and guarantees and commitments. Special purpose vehicles 36. A bank should have a detailed understanding of its contingent liquidity risk exposure and event triggers arising from any contractual and non-contractual relationships with special purpose vehicles. A bank should determine whether a special purpose subsidiary or other special purpose vehicle (in either case an SPV ) of a bank is considered to be a source or use of liquidity based upon the likelihood that such a source or use will occur if either the bank or SPV experience adverse liquidity circumstances, irrespective of whether or not the SPV is consolidated for accounting purposes. 6 Triggering events are events which enable commitments to be drawn upon and thus may create a liquidity need. For example, triggering events could include changes in economic variables or conditions, credit rating downgrades, country risk issues, specific market disruptions (eg commercial paper), and the alteration of contracts by governing legal, accounting, or tax systems and other similar changes. 12 Principles for Sound Liquidity Risk Management and Supervision

19 37. Where the bank provides contractual liquidity facilities to an SPV, or where it may otherwise need to support the liquidity of an SPV under adverse conditions 7, the bank needs to consider how the bank s liquidity might be adversely affected by illiquidity at the SPV. In such cases, the bank should monitor the SPV s inflows (maturing assets) and outflows (maturing liabilities) as part of the bank s own liquidity planning, including in its stress testing and scenario analyses. In such circumstances, the bank should assess the liquidity position of the bank with the SPV s liquidity draws (but not its liquidity surplus) included. 38. With respect to the use of securitisation SPVs as a source of funding, a bank needs to consider whether these funding vehicles will continue to be available to the bank under adverse scenarios. A bank experiencing adverse liquidity conditions often will not have continuing access to the securitisation market as a funding source and should reflect this in its prospective liquidity management. 39. As mentioned above, an SPV s liquidity surplus should not be included by a bank as a source of liquidity under adverse conditions because: (a) when a bank is experiencing severe strain, the SPV s cash surplus may cease to be available to the bank (eg the SPV s managers may be required to, or may decide to, decrease exposure to the bank for example, by depositing funds with another bank); and (b) a high correlation often exists between liquidity strains for most banks and the SPV s they sponsor and administer (eg concerns related to a bank s financial strength or the SPV s performance can trigger liquidity pressures for the other entity). Therefore, a bank should not include surplus liquidity at an SPV as a source of liquidity for the bank. Where a bank has received a deposit of surplus cash from an SPV, the withdrawal of deposits placed by the SPV with the bank could lead to a large and sudden loss of funds this should, based on the probability of such a loss, be modelled as a possible source of liquidity drain. Financial derivatives 40. A bank should incorporate cash flows related to the repricing, exercise or maturity of financial derivatives contracts in its liquidity risk analysis, including the potential for counterparties to demand additional collateral in an event such as a decline in the bank s credit rating or creditworthiness or a decline in the price of the underlying asset. Timely confirmation of OTC derivatives transactions is fundamental to such analyses, because unconfirmed trades call into question the accuracy of a bank s measures of potential exposure. Guarantees and commitments 41. Undrawn loan commitments, letters of credit and financial guarantees represent a potentially significant drain of funds for a bank. A bank may be able to ascertain a "normal" level of cash outflows under routine conditions, and then estimate the scope for an increase in these flows during periods of stress. For example, an episode of financial market stress 7 For example, a bank needs to consider that an SPV s need for liquidity could result in a draw on the bank s resources in situations where the bank sponsors a securitisation SPV and has contractual, reputational or business reasons for providing support to such SPV (for instance if customers of a bank utilised an affiliated SPV to finance their assets and then the bank would be called on to finance those assets if the SPV failed, if the bank promoted the sale of securities issued by the SPV to its customers and decided to purchase such securities to maintain its business relationships, of if the SPV is used by the bank to securitise the bank s assets and a crisis at the SPV would remove this source of funding for the bank). Principles for Sound Liquidity Risk Management and Supervision 13

20 may trigger a substantial increase in the amount of drawdowns of letters of credit provided by the bank to its customers. 42. Similarly, liquidity issues can arise when a bank relies on committed lines of credit or guarantees provided by others. For example, a bank that holds assets whose creditworthiness is dependent on the guarantees of a third party or has raised funds against such assets could face significant demands on its funding liquidity if the third party s credit standing is highly correlated with the credit quality of the underlying assets. In such cases (eg as in the experience of with a number of financial guarantors), the value of the protection a bank purchased from the guarantor on the underlying assets could deteriorate at a time when the assets also are deteriorating; moreover, the bank could be called upon to post additional margin in respect of borrowings against such assets. (c) Currencies in which a bank is active 43. A bank should assess its aggregate foreign currency liquidity needs and determine acceptable currency mismatches. A bank should undertake a separate analysis of its strategy for each currency in which it has significant activity, considering potential constraints in times of stress. The size of foreign currency mismatches should take into account: (a) the bank s ability to raise funds in foreign currency markets; (b) the likely extent of foreign currency back-up facilities available in its domestic market; (c) the ability to transfer a liquidity surplus from one currency to another, and across jurisdictions and legal entities; and (d) the likely convertibility of currencies in which the bank is active, including the potential for impairment or complete closure of foreign exchange swap markets for particular currency pairs. 44. A bank should be aware of, and have the capacity to manage, liquidity risk exposures arising from the use of foreign currency deposits and short-term credit lines to fund domestic currency assets as well as the funding of foreign currency assets with domestic currency. A bank should take account of the risks of sudden changes in foreign exchange rates or market liquidity, or both, which could sharply widen liquidity mismatches and alter the effectiveness of foreign exchange hedges and hedging strategies. 45. Moreover, a bank should assess the likelihood of loss of access to the foreign exchange markets as well as the likely convertibility of the currencies in which the bank carries out its activities. A bank should negotiate a liquidity back-stop facility 8 for a specific currency, or develop a broader contingency strategy, if the bank runs significant liquidity risk positions in that currency. (d) Correspondent, custody and settlement activities 46. A bank should understand and have the capacity to manage how the provision of correspondent, custodian and settlement bank services can affect its cash flows. Given that the gross value of customers payment traffic (inflows and outflows) can be very large, unexpected changes in these flows can result in large net deposits, withdrawals or line-ofcredit draw-downs that impact the overall liquidity position of the correspondent or custodian bank, both on an intraday and overnight basis (also see Principle 8 on intraday liquidity). A 8 As discussed in paragraphs 68-76, a bank needs to carefully manage market access to ensure that liquidity sources including credit lines can be accessed when needed. 14 Principles for Sound Liquidity Risk Management and Supervision

21 bank also should understand and have the capacity to manage the potential liquidity needs it would face as a result of the failure-to-settle procedures of payment and settlement systems in which it is a direct participant. Measurement tools 47. A bank should employ a range of customised measurement tools, or metrics, as there is no single metric that can comprehensively quantify liquidity risk. To obtain a forwardlooking view of liquidity risk exposures, a bank should use metrics that assess the structure of the balance sheet, as well as metrics that project cash flows and future liquidity positions, taking into account off-balance sheet risks. These metrics should span vulnerabilities across business-as-usual and stressed conditions over various time horizons. Under business-asusual conditions, prospective measures should identify needs that may arise from projected outflows relative to routine sources of funding. Under stress conditions, prospective measures should be able to identify funding gaps at various horizons, and in turn serve as a basis for liquidity risk limits and early warning indicators. 48. Management should tailor the measurement and analysis of liquidity risk to the bank s business mix, complexity and risk profile. The measurement and analysis should be comprehensive and incorporate the cash flows and liquidity implications arising from all material assets, liabilities, off-balance sheet positions and other activities of the bank. The analysis should be forward-looking and strive to identify potential future funding mismatches so that the bank can assess its exposure to the mismatches and identify liquidity sources to mitigate the potential risks. In the normal course of measuring, monitoring and analysing its sources and uses of funds, a bank should project cash flows over time under a number of alternative scenarios. These pro-forma cash flow statements are a critical tool for adequately managing liquidity risk. These projections serve to produce a cash flow mismatch or liquidity gap analysis that can be based on assumptions of the future behaviour of assets, liabilities and off-balance sheet items, and then used to calculate the cumulative net excess or shortfall over the time frame for the liquidity assessment. Measurement should be performed over incremental time periods to identify projected and contingent flows taking into account the underlying assumptions associated with potential changes in cash flows of assets and liabilities. 49. Given the critical role of assumptions in projecting future cash flows, a bank should take steps to ensure that its assumptions are reasonable and appropriate, documented and periodically reviewed and approved. The assumptions around the duration of demand deposits and assets, liabilities, and off-balance sheet items with uncertain cash flows and the availability of alternative sources of funds during times of liquidity stress are of particular importance. Assumptions about the market liquidity of such positions should be adjusted according to market conditions or bank-specific circumstances. Liquidity risk control through limits 50. A bank should set limits to control its liquidity risk exposure and vulnerabilities. A bank should regularly review such limits and corresponding escalation procedures. Limits should be relevant to the business in terms of its location, complexity of activity, nature of products, currencies and markets served. 51. Limits should be used for managing day-to-day liquidity within and across lines of business and legal entities under normal conditions. For example a commonly employed type of limit constrains the size of cumulative contractual cashflow mismatches (eg the cumulative net funding requirement as a percentage of total liabilities) over various time Principles for Sound Liquidity Risk Management and Supervision 15